Banks have long held a significant informational advantage over their customers, particularly when it comes to small businesses. This dominance has led to what can be described as an “information monopoly” that hampers competition in the lending market. In this environment, small businesses struggle to secure more favourable loan terms, switch lenders, or negotiate competitive rates. However, a new study reveals that deposit relationships, especially across multiple banks, can break this monopoly and level the playing field for borrowers. This article explores how deposit data sharing can contribute to more competitive lending markets, benefiting both borrowers and lenders alike.
The Problem: Incumbent Banks’ Information Monopoly
One of the most significant barriers to improved access to financing for small businesses is the information monopoly that incumbent banks have over their customers. Small businesses typically rely on their bank to not only provide loans but also manage their day-to-day financial operations through deposit accounts. This dual relationship gives the bank access to crucial financial data, including cash flow patterns, transaction history, and creditworthiness.
However, this informational advantage often puts small businesses at a disadvantage. The incumbent bank knows the borrower’s financial health inside and out, which allows it to charge higher interest rates or impose unfavourable loan terms without the fear of losing the customer to competitors. This creates a situation where small businesses are often stuck with their current bank, unable to shop around for better deals or negotiate terms more suited to their needs.
This information monopoly also results in what is known as “hold-up problems,” where businesses are forced into agreements that benefit the bank more than the borrower. Additionally, the lack of transparency in the lending process can lead to investment inefficiencies. In other words, small businesses may not be able to access the capital they need to grow, while banks continue to profit from their monopoly.
The Solution: Deposit Relationships and Data Sharing
A recent paper by Cao et al. (2024) sheds light on a potential solution to this issue: deposit relationships. The researchers found that when firms maintain deposit relationships with multiple banks, it significantly reduces the information advantage of incumbent banks. This is because competing banks can gain access to valuable data about a firm’s financial health through its transaction history and deposit patterns.
These insights enable lenders to make more informed lending decisions, thereby increasing competition in the market. When competing banks can observe a company’s cash flow, income streams, and spending habits, they are better equipped to offer competitive loan terms. In this way, the monopoly of incumbent banks is diminished, and firms are empowered to shop around for the best financing options.
The Data Behind the Solution
Using comprehensive data on deposit and loan relationships from Norway, the study found that firms with deposit accounts at competing banks were 8 percentage points more likely to switch lenders than those that only had loan relationships with one bank. This marks a 50% increase in the likelihood of switching lenders, highlighting how deposit relationships can create opportunities for greater competition in the lending market.
The findings also revealed that a significant proportion of firms that successfully switched banks had a pre-existing deposit relationship with their new lender. In fact, 40% of firms that switched to a new bank had maintained a deposit relationship with that bank prior to making the switch.
The Structure of Firm-Bank Relationships
The research also delved into the structure of firm-bank relationships. It found that approximately 20% of firms maintained more deposit relationships than lending relationships, suggesting that these firms were in a stronger position to negotiate better loan terms. Conversely, firms with only a lending relationship were at a disadvantage, as they had less leverage when dealing with their bank.
Figure 1: The Structure of Firm-Bank Relationships
Figure 1 shows the proportion of firm-bank relationships that consisted of both a deposit and lending relationship (in blue), only a deposit relationship (in red), and only a lending relationship (in green). The data suggests that firms with deposit relationships across multiple banks are better positioned to shop around for financing options.
Figure 2: Proportion of Switching Firms with Pre-existing Deposit Relationships
Figure 2 illustrates the proportion of firms that switched lenders and had a pre-existing deposit relationship with their new bank (blue) compared to those who did not (red). The findings indicate that deposit relationships significantly increase the likelihood of switching lenders, providing evidence that deposit data sharing can stimulate greater competition in the market.
The Benefits of Deposit Relationships for Borrowers and Lenders
For borrowers, deposit relationships with multiple banks provide more leverage when negotiating loan terms. Not only does this make it easier to switch banks, but it also means that lenders are more likely to offer better terms to customers who have a deeper financial relationship with them. In the competitive lending market, offering favourable terms can be a strategic way for banks to attract new clients.
For banks, the ability to access a broader range of transaction data from competing banks could encourage them to offer more competitive interest rates, which, in turn, could drive business growth. The competition generated by data sharing would push banks to innovate in how they approach lending, fostering better financial products and services for small businesses.
Policy Implications: Open Banking and Data Sharing
The findings of the study have important implications for policymakers and regulators, particularly in the areas of open banking, data sharing, and competition policy. The results suggest that encouraging deposit data sharing could help unlock more competitive lending markets and improve access to financing for small businesses.
Open banking initiatives, which allow third-party providers to access bank data (with the customer’s consent), could be an effective way to level the playing field between incumbent banks and new entrants. By giving competing lenders access to the same financial data, small businesses could have more opportunities to secure financing from a broader pool of lenders, ultimately benefiting from better loan terms and lower interest rates.
Additionally, deposit market reforms could be key to improving competition. If firms were encouraged to maintain deposit relationships with multiple banks, they could enjoy more flexibility when it comes to securing loans. This could drive innovation in the lending sector, improve financial inclusion, and promote healthier competition among banks.
In conclusion, deposit relationships and data sharing could be key to breaking incumbent banks’ information monopoly and fostering more competitive lending markets. By empowering small businesses to switch lenders and negotiate better terms, these practices could lead to more efficient capital allocation and better financial outcomes for borrowers and lenders alike. The policy implications are clear: enabling greater access to financial data through open banking and deposit sharing could drive greater competition, lower borrowing costs, and ultimately promote economic growth.
